The War on Capitalism

European leaders take aim at free markets.

The next morning, ECB President Jean-Claude Trichet effectively blew off percolating market concerns by adopting a "What, Me Worrry?" attitude at the ECB meeting and the stage was set for the global fret. (See: ECB Tries to Avoid a Sovereign Debt Contagion.)

It remains to be seen if this new structural backstop will achieve the desired results -- or if it's logistically feasible -- given the European crisis is but one of many global concerns. Let's not forget that US states are in a similarly dire financial condition, as are many US citizens. And there's the matter of the crash itself.

The question we must wrestle with is one of psychology, which is "why" the events last Thursday pales in comparison to "what" actually transpired.

Unintended Consequences

Faith in the system and the credibility of our leaders has long been fingered as the issue at hand for markets at large. (See: The Credit Card.)

Decisions made in a state of panic tend to have serious repercussions. We witnessed this dynamic evolve during the last eighteen months as the unintended consequences of government intervention manifested. From moral hazard to record profits -- and bonuses -- at financial institutions to the attendant class war and shifting social mood, risk wasn't destroyed; it simply changed shape.

What if high-frequency trading actually provides liquidity in the marketplace? It's conceivable that Thursday's 1000-point swoon was triggered by computerized models "pulling bids" at precisely the same time. If that's the case -- I'm not saying it was, I'm simply posing the possibility -- banning the robots would lead to more, not less, market volatility.

What if "naked CDS" are banned, as we've long suspected might happen? The knee-jerk reaction would likely be a melt-up in the equity space, but we could then see "counter-party contagion" given the $500 trillion dollars of notional derivatives tying the world together. If you think there was confusion Friday when mom & pop couldn't get a handle on their exposure, imagine the domino effect if JP Morgan (JPM), Goldman Sachs (GS), Bank of America (BAC), Citigroup (C), and Morgan Stanley (MS) suddenly have billions of dollars of unidentified risk. (See: Regulatory Risk Abounds!)

And what if the reaction to last week's crash causes investors -- many of whom have been burned multiple times during the last decade -- to lose faith in the system, if only for a spell? While psychology can be manipulated for extended periods of time, free will can never be caged. If you doubt that for a moment, read Victor Frankl's Man's Search for Meaning.

The reaction to the EU Emergency Fund will be entirely more telling than the Fund itself, and while markets feel euphoric thus far this week, there is cause for pause.

According to Jason Goepfert at Sentimentrader.com, there have been six other instances when the market gapped up more than 4%, as it did Monday. In every single case, the "gap" was eventually filled, and usually very quickly. For purposes of clarity, the downside vacuum in the current marketplace resides under S&P 1150 (which, if breached, "works" to S&P 1110) and Nasdaq 1925 (which, if breached, "works" to NDX 1850).

(Click charts to see larger versions.)

While technical context could provide utility in the battle for the few percent, it pales in comparison to the war of words and the monetary mortars flying overhead. Make no mistake, in the eyes of our leaders, the stability and fragility of the global financial markets is a matter of national security and they'll fight to the end to defend their turf.

While speculators and hedge funds are currently in the political crosshairs, widely perceived to be acceptable casualties of the current conflict, the future of free-markets hangs in the balance. Let's just hope that in the quest to win the war on capitalism, we don't lose something entirely more profound in the process.